MANUAL DE CALIBRACIÓN Y OPERACIÓN DEL TÚNEL DE VIENTO

Economists assess policy proposals in terms of the proposal’s effect on efficiency, equity, and growth. Analysis of efficiency typically involves assessing the extent to which the proposal leads to distortion in investment or consumption choices, as such distortion usually leads to wasted economic resources. Analysis of equity typically involves judgments as to what constitutes a “fair” outcome. Analysis of growth typically involves assessment of a policy’s potential to increase the future well being of the residents of the economy. Often policies that promote one of the three goals involve a tradeoff with the other two goals. For example, a policy promoting growth may distort market choices and may produce outcomes that many see as inequitable. A policy that promotes one standard of fairness may involve slower prospects for growth.

The findings of the 2006 GAO study suggest that there are underutilized labor resources in Puerto Rico and an inadequate rate of investment necessary to reduce the gap in income between the United States and Puerto Rico. In the past the Congress has made efforts to reduce the income gap through increasing investment and employment in Puerto Rico by enacting targeted tax benefits and through other measures. Proposals to provide tax benefits to foster Puerto Rico development typically have a goal of attempting to “distort” taxpayer’s behavior. For example, prior law section 936 effectively increased the after-tax return to investments in Puerto Rico. In response, some taxpayers located production facilities in Puerto Rico that they may have chosen to locate in another jurisdiction (domestic or foreign) in the absence of the tax benefit. The policy challenge is to promote faster growth in Puerto Rico without materially harming growth in the States or other territories and without creating too much market distortion. An additional policy challenge is discerning when increased growth in Puerto Rico is self

sustaining so that the distortions or unequal treatment created by a pro-development tax benefit does not become a permanent feature of the Code.

Federal tax policy as a development tool

Federal taxpayers in the Puerto Rico economy

U.S. Federal tax incentives may be a limited tool in the promotion of economic development in Puerto Rico. A tax incentive operates by providing the taxpayer with tax benefits, a reduction in total tax burden, in return for certain behavior. U.S. Federal tax benefits can be delivered only to U.S. taxpayers. U.S. taxpayers are not the sole source of potential investment or employment opportunities in Puerto Rico. Local Puerto Rico investors and foreign investors can be important sources. The GAO estimates that in 2002, possessions corporations accounted for approximately one-third of the manufacturing payroll in Puerto Rico155 and less in

155 _{Id. at 158 and 164. CFCs of U.S. parent corporations account for another one sixth to one}

fifth of manufacturing payroll. In other industries, U.S. taxpayers account for smaller shares of

employment than in manufacturing. The GAO estimates that in 2002 U.S. taxpayers, through possessions corporations, CFC, or other U.S. corporations, accounted for 28 percent of employment in the

all other industries. Even significant change in U.S. taxpayer activity in Puerto Rico may have only modest effects on the overall Puerto Rico economy. However, a U.S. Federal tax incentive would be expected to increase the presence of U.S. taxpayers in the Puerto Rico economy. The GAO documents that possessions corporations accounted for more than 38 percent of

manufacturing payroll in Puerto Rico in 1987 and the GAO suggests that the lower reported percentage in 2002 may reflect the reduction in U.S. Federal tax benefits since 1995.156 Moreover, while employment by U.S. Federal taxpayers accounts for a minority of direct employment opportunities in Puerto Rico, employment by these taxpayers can increase the demand for local consumer services provided by local employers and be the source of employment through subcontracting. The importance of the investment and employment opportunities resulting from U.S. tax incentives with respect to activities in Puerto Rico is not measured solely by the direct investment and direct employment by Federal taxpayers.

From the perspective of Puerto Rico, a tax benefit that is limited to only U.S. taxpayers may diminish the efficiency of the development outcome by excluding other potential business owners who may be able to achieve the same outcome as the U.S. taxpayer at a lower level of subsidy.157 Theoretically, if the Puerto Rico government were given the estimated dollar value of a proposed tax benefit as a grant, and if the Puerto Rico government chose wisely, a larger growth effect would result from being able to allocate the value of the tax expenditure across potential investors and employers other than solely those who are U.S. taxpayers. Alternatively, if a particular tax incentive were determined to be an efficacious development tool, Puerto Rico could provide comparable non-U.S. owned businesses with comparable incentives.

Some problems constraining development may not be tax problems

The GAO reports that labor force participation is lower in Puerto Rico than in the 50 States. The 2006 GAO study notes that labor supply may be discouraged because of the

magnitude of government benefits available to those outside of the labor force. Alternatively, a low demand for labor could lead some individuals to stop seeking employment (i.e.,

“discouraged workers”). Some have suggested that the fact that the U.S. minimum wage applies in Puerto Rico may discourage hiring of lower skilled workers who become discouraged.

Neither of these possible causes for low labor force participation is a result of Federal tax policy. A potential tax solution, to be effective in changing these employment-related problems, would

accommodation and food services industry, 26 percent of employment in retail trade, 23 percent of employment in wholesale trade, 15 percent of employment in health care and social assistance, and 21 percent of employment in the administrative support and waste management sector, the next five largest employment sectors after manufacturing.

156 _{Id. at 81. Possessions corporations accounted for 61.6 percent of value added in Puerto Rico}

manufacturing in 1987 and 26.7 percent in 2002.

157 _{If it were advantageous, potential local or foreign investors could reincorporate as U.S.}

taxpayers to avail themselves of a U.S. Federal tax subsidy, but such reincorporation suggests a distortion of choice of business structure and an inefficiency created by the tax subsidy.

need to be generous enough to offset non-tax effects. A direct approach could involve changing existing government benefit programs or the minimum wage, if those were thought to be the primary cause of low labor force participation. A potential tax solution may not be able to be targeted at the appropriate group of affected individuals and would create inefficiencies.

A lack of infrastructure (such as roads or waste water treatment facilities) may forestall certain business investments. It is difficult for tax benefits to address those sorts of business development initiatives. Use of a tightly defined tax benefit as a business development tool may constrain the availability of Federal Government funds for other development initiatives that might foster business development in Puerto Rico. More generally, one might question the efficacy of using tax benefits in lieu of direct spending to foster economic development. Direct subsidies could be made to certain businesses to encourage location in Puerto Rico, and the subsidies could be tailored to the specific circumstance of the business, whereas a tax benefit operates as an open-ended entitlement to any business that is eligible to claim the benefit. On the other hand, unlike direct subsidies, under a tax benefit, the marginal investment decisions are left to the private sector rather than being made by government officials. Economists generally argue that private market outcomes promote a more efficient use of limited resources.

Identification of problems limiting economic development in Puerto Rico

The 2006 GAO study notes, and the Office of the Governor of Puerto Rico highlights, that manufacturing employment has fallen in Puerto Rico. However, the loss of manufacturing jobs is not a phenomenon unique to Puerto Rico. The 50 States also have experienced a loss of manufacturing jobs, though, as the GAO documents, the rate of loss of manufacturing jobs has been greater in Puerto Rico than in the 50 States. Nevertheless, the reason for some of the job loss is the same in Puerto Rico as in the 50 States. Increased internationalization of product markets and reduced transportation costs (in relation to final goods’ prices) have made

outsourcing of many lower-skilled manufacturing operations profitable. Puerto Rico, like the United States in general, has a more educated, higher-wage labor force than much of the rest of the world and analysts would expect some of the same pressures on business to relocate to lower labor cost locations to work to the detriment of Puerto Rico as they do to the 50 States. Some observers blame institutional factors such as labor laws and environmental regulations for the loss of manufacturing jobs in certain industries. Generally Puerto Rico shares these institutional factors with the United States. A policy designed for Puerto Rico to counteract a problem that is common to the United States is likely to induce businesses to relocate from the United States to Puerto Rico. This may result in gains to the Puerto Rico economy largely at the expense of the rest of the United States. A policy to foster economic development in Puerto Rico is likely to be more efficient if it can target problems that are unique to Puerto Rico.

Coordination of U.S Federal tax policy with local policy

The Puerto Rico corporate income tax rate generally applicable to the larger incomes that would be earned on larger investments is 39 percent, substantially above corporate income tax rates in the 50 States, and higher than the highest Federal tax rate applicable to corporate

income.158 In addition to taxation at the corporate level, dividends received from Puerto Rico corporations are generally subject to a flat 10-percent tax in Puerto Rico.159 In the potential investor’s calculation, a Federal tax reduction related to investments in Puerto Rico would reduce the combined U.S. and Puerto Rico tax liabilities. If tax reductions for U.S. taxpayers locating in Puerto Rico to encourage relocation of potential investments to Puerto Rico were enacted and Puerto Rico raises its local taxes, the incentive effect of the Federal tax reduction would be diminished. Such an outcome would also have the, perhaps unintended, effect of converting the U.S. Federal tax reduction into a revenue sharing program with Puerto Rico.160 More generally, policy makers may want to consider coordination between local development initiatives and any possible U.S. Federal tax benefit. For example, tax benefits targeted at one industry or one type of industry may work at cross purposes to initiatives in Puerto Rico if Puerto Rico’s plans for development do not include such investments. With respect to U.S. Federal tax benefits, as noted above, absent changes in business structures, some potential investors are neither U.S. taxpayers nor subsidiaries of U.S. taxpayers. Puerto Rico may target local tax benefits to such taxpayers to encourage investment while leaving U.S. Federal tax policy to provide benefits encouraging investment for U.S. taxpayers.

158 _{As noted above, there are many special exceptions such that many taxpayers may not be}

subject to the 39-percent tax rate. Special tax incentives are offered by Puerto Rico under the Puerto Rico Tax Incentives Act of 1998. Certain U.S. Federal taxpayers may qualify under this law and, thereby, not be subject to the local tax at a rate of 39 percent. Although the tax incentive law is public information, the identity of those companies receiving these tax benefits, and the value of such benefits, is not public information. It is widely believed that currently U.S. companies or subsidiaries of U.S. companies receive the majority of these incentives.

U.S. Federal taxpayers not organized as C corporations are subject to different tax rules in Puerto Rico which may impact the decision of these taxpayers to avail themselves of a U.S. Federal tax benefit designed to foster economic development in Puerto Rico. In Puerto Rico a special set of tax laws permits certain closely held corporations known as a “corporation of individuals,” similar to the U.S.-law

Subchapter S provisions, to elect Puerto Rico income taxation solely at the individual shareholder level, which has a top marginal income tax rate of 33 percent. (See, ERNST & YOUNG, supra note 46, at 50 (2004). P.R. Code sec. 1390 (c); 13 L.P.R.A. sec. 8680 (c).) Although pass-through treatment similar to that offered under U.S. partnership tax law is not generally available to partnerships or limited liability corporations in Puerto Rico, a partnership may qualify as a corporation of individuals if it otherwise meets the requirements. It appears that only corporations may qualify for tax incentives under the Puerto Rico Tax Incentives Act of 1998.

159 _{ERNST & YOUNG, supra note 46, at 47 (2004). P.R. Code sec. 1012; 13 L.P.RA.}

sec. 8412.

160 _{The calculation of the total size of the Federal tax benefit and the total combined Federal and}

Puerto Rico tax would depend upon the structure of the proposed tax benefit. For example, would a U.S. taxpayer be allowed to claim the foreign tax credit for taxes paid to Puerto Rico in addition to any reduction in U.S. income taxes that may be permitted as part of the tax benefit?

Issues in the design of a new tax policy instrument to enhance development

In the design of a tax incentive for development, a permanent provision, as opposed to a temporarily effective provision, tends to carry out the policy more effectively. Because many large investment plans implemented take many months to plan and execute, a policy of tax benefits enacted with a requirement that taxpayers make necessary investments within a short period of time is more likely to see the tax benefits claimed by taxpayers who already were planning such investment in the absence of the policy – a windfall to such taxpayers.

Completely new investments are unlikely to be induced, because taxpayers need adequate time to learn of the incentive and make plans. In some cases, learning by doing may enhance the

efficacy of a tax incentive as the same taxpayer makes multiple investments based on his or her earlier experience. Successful development might result in self-sustaining future growth in Puerto Rico. If such a result occurs, a policy initiated to spur investment may, at some point, no longer be necessary, so a sunset date may be appropriate.

If a proposed policy initiative differs from tax incentives previously enacted to foster development, some consideration should be given to whether transition should be provided to taxpayers claiming the old benefits to enable them, without penalty, to claim the new tax benefits. To the extent that taxpayers already located in Puerto Rico become eligible for a new tax benefit, the new tax benefit may provide a windfall reduction in Federal tax liability to the taxpayer, yet provide no additional benefits to growth of the Puerto Rico economy. For other taxpayers, however, the new tax benefits may remain necessary to help maintain existing business operations that may otherwise have ceased operation. In this case, if such businesses are part of the development plan, transition relief may be necessary. It may be difficult to distinguish for which businesses transition relief results in a windfall benefit and those businesses that require further implicit subsidy from the new tax benefit in order to maintain their operations. If one goal of development is to create a local economy that has self-sustaining growth and if a tax benefit is provided to entice a taxpayer to retain his or her operation in Puerto Rico rather than relocating outside Puerto Rico, one may ask whether the tax benefit has become a permanent subsidy to the taxpayer and inconsistent with self-sustaining growth.

VI. SUMMARY OF STATEHOOD, COMMONWEALTH, AND INDEPENDENCE STATUS161

A. Description of Statehood Agenda